The Business of Equity

offerings and IPOs

Lecture 10

1-1
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 2

Definition
◼ Raising equity capital is traditional role and
core business of investment banks, which
they do for their customers
◼ IPO (Initial public offering): sell stock to the
general public for the first time and get listed
on the stock market
◼ SEO (Seasoned equity offering): offering of a
stock that is already listed
 3

Alternative IPO Methods

◼ Auction: shares are offered for sale, on a pre-
determined schedule, to several competing potential
buyers
◼ Fixed-price offering: a certain number of shares are
offered to retail investors at a preset price, which is
generally identical to the price offered to
institutional investors
◼ Book building: Bank marketing the IPO gets to know
the price investors intend to offer and the volume of
security they are interested in
 4

Auction mechanisms
◼ Two types of IPO auctions:
◼ Single-price auction (Uniform-price auction): All
winning bidders pay the same price (which is
the lowest price among winning bidders)
regardless of the prices they bid
◼ Discriminatory auction (Pay what you bid):
Winning bidders pay the price they bid
 5

Fixed-price offerings
◼ The firm indicates number of shares and the
proposed price, without any consideration for
the demand
◼ Any interested investor indicates to his bank
the number of shares he wishes to purchase
at that price
◼ Tend to have high level of underpricing
◼ It is almost never used now. Can be combined
with book building
 6

Book building
◼ It is an underwritten offer: underwriter guarantees
the proceeds
◼ Also called a “bought deal” or “firm commitment”
◼ Issuer sells its securities outright to underwriter, who
then resells securities to dealers and general public
◼ DPO (Direct public offering): Issuer sell its shares
directly to public without the help of underwriters
◼ Best-effort underwriting: Underwriters agree only to
do their best to sell shares to the public. This is
common for small IPOs
 7

Book building
◼ In a firm commitment underwriting, underwriters’
risks are reduced by the book-building process
◼ They can test demand through advance gathering of
indications of interests (premarketing phase or “road
show”)
◼ Underwriter has some influence on the offer price
and allocation of shares
◼ Investors have a built-in incentive to truthfully reveal
their interests as the allocation of shares depends on
the information revealed by investors
 8

IPO Process
◼ Two important dates: filing date and effective
date
◼ Filing date: the issuer files the registration statement
with the SEC
◼ Effective date: everything is satisfactory with the SEC,
an offer price is set, prospectus becomes effective,
and a full-fledged selling effort gets underway
◼ Three important periods: prefiling period,
waiting period, posteffective period
 9

Prefiling period
◼ Registration statement: includes description of the issuing
company, biography of its officers and directors, number of
shares owned by each insider (officers, directors, and
shareholders owning more than 10% of the securities),
complete financial statements, use of funds (how the issuer
use the proceeds from the issue), any present or impending
legal proceedings including strikes, lawsuits, antitrust actions,
copyright/patent infringement suits
◼ Lead underwriter: an investment bank is chosen as the
lead underwriter who is responsible for preparing and
executing the deal, and serves as book runner in pricing and
allocation of IPO shares
 10

Prefiling period
◼ Underwriting syndicate: group of underwriters
selling shares to the public
◼ Five departments of lead underwriter are involved:
◼ Banker, or relationship manager, and Corporate finance
department
◼ Equity capital markets group (ECM)
◼ Equity sales
◼ Equity traders
◼ Sell-side analysts
 11

Waiting period
◼ The period between filing registration statement and
it being declared effective by SEC
◼ Underwriter performs due diligence investigation,
receives SEC comments and files amendments,
prepares road show (including presentation, retail
information memorandum, and preliminary
prospectus)
◼ Issuer is required to disclose all material information
to potential investors or be held liable for its absence
 12

Waiting period
◼ During quiet period, issuer is prohibited from talking
about its stock, typically lasts 90 days after filing date
◼ Following an IPO, NYSE and NASDAQ rules imposed a
quiet period of 40 calendar days on underwriting
managers and co-managers and of 25 calendar days
on other members of underwriting syndicate or
selling group
◼ SEC investigates and makes sure that full disclosure
has been made in the registration statement
 13

Waiting period
◼ Registration statement is the source of prospectus (or
“offering circular”)
◼ Prospectus: see p.164 textbook
◼ Preliminary prospectus: also called “red herring” because
of red warnings across the top and down the side
explaining that “this is not the solicitation for sale”
◼ Preliminary prospectus is the only source of information.
No other written information about the offering can be
published, no analyst can publish research report on the
company, no journalist can write stories about the IPO,
the issuing firm, or its banks’ involvement
 14

Waiting period
◼ With preliminary prospectus in hand, issuing company
and its bankers embark on the road show (traveling
presentation by company managers to potential
investors, series of meetings organized by the bank for
most important potential investors)
◼ Objectives of road show: promote the issuer, build the
order book, prepare placement of the shares
◼ Road show starts with a price range which is also
indicated to the SEC in the filing
 15

Waiting period
◼ Indication of interest (IOI): how many shares an investor
would demand at a given price (or a given price range)
◼ Book runner uses indication of interest (IOI) from
investors to build order book
◼ If demand is too strong or too weak, issuer and
underwriters may want to revise the price range and file
it with the SEC. Amendment with the revised price range
must be filed with the SEC if the final offer price is set
more than 20% above or more than 20% below the last
price range
 16

Posteffective period
◼ The offer price is set
◼ Shares are allocated to investors
◼ Decide on selling, or not selling, more shares than the
number of shares offered
◼ Underwriting agreement is signed
◼ Press release with the terms of the offering is issued
◼ The final prospectus is printed
◼ The transaction closes
 17

Posteffective period
◼ Offer price is determined by the issuing company based
on the lead underwriter’s pricing recommendations
◼ The company files the offer price with the SEC in the
last amendment
◼ All warnings are removed and red herring becomes
final prospectus
◼ Once the underwriting agreement is signed,
underwriters become owners of the issue, stock can be
offered to the general public and underwriting risk
starts
 18

Posteffective period
◼ If offer price is too low, there is “money left on the
table” or IPO underpricing
◼ Money left on the table = first-day capital gain x
number of shares offered
◼ If offer price is too high, underwriters can be stuck
with the issue
◼ If underwriters cannot sell all the shares, the market
price is more likely to stay below the offer price
 19

Posteffective period
◼ Book runner has discretion over who receives
allocations of IPO shares
◼ Gives priority to large customers and institutions
◼ Lead underwriter should disclose and explain to
the issuer the final allocation of its IPO shares
◼ Unlawful allocation of IPO shares: “Spinning”,
“Quid pro quo arrangements”
 20

Posteffective period
◼ “Spinning”: allocating IPO shares to an executive in a
company in exchange for the company’s future
investment-banking business
◼ “Quid pro quo arrangements”: investment banks
allocate hot IPO to their favored customers in return
for commission business
◼ “Issuer-directed securities”: a legal practice. They are
amounts of stock that the issuer reserves for its
employees and friends or customers. About 10% of
the issue
 21

Posteffective period
◼ “Flipping”: buying shares at the offer price and
reselling them as soon as trading begins. Most
profitable in a hot IPO market. It is discouraged by
penalizing investors for doing so
◼ “Laddering”: Underwriters require investors to agree
to purchase additional shares in the aftermarket at
specified prices in order to boost demand and support
the price. It is unlawful practice
 22

Posteffective period
◼ Price stabilization by the lead underwriter: placing a
stabilizing bid at the offer price when the market price
drops below the offer price
◼ If underwriters sell more shares than the number
offered, they have to buy shares in the aftermarket to
deliver them, or exercise an overallotment option
(“Green shoe option”) to buy additional shares from
the issuing company
 23

Posteffective period
◼ Underwriting agreement: public offer price,
underwriting spread, net proceeds to the issuer, and
settlement date
◼ Underwriting spread, or “gross spread”: the total
underwriters’ fee, about 7% in the U.S., 3-3.5% in
Europe. Has three components:
◼ Management fee
◼ Underwriting fee
◼ Selling concession